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Why We’re Not Keen On Continental Aktiengesellschaft’s (FRA:CON) 6.6% Return On Capital

Simply Wall St

Today we are going to look at Continental Aktiengesellschaft ( FRA:CON ) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. And finally, we'll look at how its current liabilities are impacting its ROCE.

Understanding Return On Capital Employed (ROCE)

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. Generally speaking a higher ROCE is better. Overall, it is a valuable metric that has its flaws. Author Edwin Whiting says to be careful when comparing the ROCE of different businesses, since 'No two businesses are exactly alike.'

So, How Do We Calculate ROCE?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Continental:

0.066 = €1.8b ÷ (€44b - €17b) (Based on the trailing twelve months to June 2019.)

Therefore, Continental has an ROCE of 6.6%.

Check out our latest analysis for Continental

Is Continental's ROCE Good?

ROCE can be useful when making comparisons, such as between similar companies. We can see Continental's ROCE is meaningfully below the Auto Components industry average of 9.0%. This performance could be negative if sustained, as it suggests the business may underperform its industry. Setting aside the industry comparison for now, Continental's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. Investors may wish to consider higher-performing investments.

Continental's current ROCE of 6.6% is lower than its ROCE in the past, which was 21%, 3 years ago. Therefore we wonder if the company is facing new headwinds. You can see in the image below how Continental's ROCE compares to its industry. Click to see more on past growth.

DB:CON Past Revenue and Net Income, August 21st 2019

When considering ROCE, bear in mind that it reflects the past and does not necessarily predict the future. ROCE can be misleading for companies in cyclical industries, with returns looking impressive during the boom times, but very weak during the busts. ROCE is, after all, simply a snap shot of a single year. What happens in the future is pretty important for investors, so we have prepared a free report on analyst forecasts for Continental .

Do Continental's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To check the impact of this, we calculate if a company has high current liabilities relative to its total assets.

Continental has total assets of €44b and current liabilities of €17b. Therefore its current liabilities are equivalent to approximately 39% of its total assets. Continental's ROCE is improved somewhat by its moderate amount of current liabilities.

Our Take On Continental's ROCE

Despite this, its ROCE is still mediocre, and you may find more appealing investments elsewhere. You might be able to find a better investment than Continental. If you want a selection of possible winners, check out this free list of interesting companies that trade on a P/E below 20 (but have proven they can grow earnings).

I will like Continental better if I see some big insider buys. While we wait, check out this free list of growing companies with considerable, recent, insider buying.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com . This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.